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Wednesday, January 18, 2017

Study Shows Electricity Markets Are More Cost-Effective Than Cost of Service Regulation - Natural experiment using the U.S. electricity system shows regions using a market approach save about $3 billion a year.

Are markets more cost-effective than cost of service regulation and other approaches? Despite markets’ imperfections, a new natural experiment using the U.S. electricity system points to yes. The study finds that regions using a market approach to buy and trade electricity save about $3 billion a year because of the increased efficiencies and coordination the markets bring.

“While many have compared major differences in economic systems across countries—where there are many moving parts and it’s difficult to convincingly identify the true source of those differences—this study focuses on a single industry that has undergone a profound reorganization,” says Steve Cicala, the author of the study and an assistant professor at the University of Chicago Harris School of Public Policy. “The study is an additional piece of evidence that, while not perfect, markets perform well relative to the alternative.”

Cicala used a unique policy shift within the U.S. electricity system to compare a market versus command-and-control regulatory structure. Periodically since the late 1990’s, some regions of the country changed overnight from using vertically-integrated local monopolies to make power decisions to a decentralized market-based auction system. Cicala constructed a virtually complete hourly characterization of U.S. electric grid supply and demand from 1999 to 2012 and compared the data in wholesale electricity markets versus regulated command-and-control areas before and after the market was introduced. In doing so, Cicala looked at two key measures: “out of merit” costs and trade across utility service territories.

The “out of merit” costs occur when power plant operators don’t use the lowest-cost available plants because those plants are forced to go off-line for maintenance or some other reason. The additional cost of output from the more expensive plants relative to the lowest-cost units is the out of merit cost. The study finds that power plant generators operating within markets are more likely to ensure their power plants are available to run when it is most economical for them to run. This means the lowest-cost plants are used 10 percent more often in market regions—reducing out of merit costs by nearly 20 percent.

Trade between utilities is also a factor. When importing electricity from another area, one could save having to fire up a more expensive unit. When exporting, one could gain any additional revenue beyond that required to generate the power. The study finds that generators operating within markets are able to better identify low-cost generators across areas and better coordinate the dispatch of power, increasing trade by 10 percent. The savings from these transactions increases by 20 percent a year.

“Some policymakers are right now deciding whether their state should join a market system, while others are deciding whether they should return to the regulated approach,” says Cicala. “While these markets are certainly vulnerable to market power, this study shows that previously unmeasured cost reductions far outweigh those losses."

This paper measures changes in electricity generation costs caused by the introduction of market mechanisms to determine output decisions in service areas that were previously using command-and-control-type operations. I use the staggered transition to markets from 1999- 2012 to evaluate the causal impact of liberalization using a nationwide panel of hourly data on electricity demand and unit-level costs, capacities, and output. To address the potentially confounding effects of unrelated fuel price changes, I use machine learning methods to predict the allocation of output to generating units in the absence of markets for counterfactual production patterns. I find that markets reduce production costs by $3B per year by reallocating output among existing power plants: Gains from trade across service areas increase by 20% based on a 10% increase in traded electricity, and costs from using uneconomical units fall 20% from a 10% reduction in their operation.

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